Agreement at last, but the hard work is far from over

The tougher prudential rules for banks that have – almost – been agreed by the European Parliament and the European Union’s member states are by no means the end of the banking-reform story. While they are a piece of the post-Lehman jigsaw aimed at ensuring that the task of saving the financial industry is no longer shouldered by taxpayers, the giant leap that EU policymakers promised three years ago is still in mid-air.

For all the talk about what these rules will do for bankers’ bonuses, the legislation that finance ministers discussed on Tuesday (5 March), after last week’s provisional deal with MEPs, is about much more. European policymakers still want to draw “lessons from the crisis”, was how Michel Barnier, the European commissioner for the internal market, put it after Tuesday’s meeting. This is far from a revelation. Barnier has been determined to suffocate behaviour that he believes leads to the sort of excessive risk-taking that triggered the financial turmoil ever since taking office.

All the rules contained in CRD IV, a revision of the EU’s capital- requirements directive, and a new capital requirements regulation (which gives member states no room for manoeuvre in implementation), are designed to restrict risk. Banks will have to hold greater capital buffers, and these can be increased further for specific institutions, at specific times and even for specific activities, such as real-estate lending. The initial draft of the legislation did not include plans to limit bankers’ bonuses, which were added by the Parliament and then received support from the European Commission. Barnier and his team believe that the massive payments given to bankers encouraged them to gamble because of the personal rewards on offer. The taxpayer was left picking up the pieces when the games of chance went wrong.

So far, so good. But the Commission’s plan to limit the excesses of the financial industry is far from complete. The ‘single rulebook’ idea introduced by CRD IV as one set of harmonised prudential rules for all banks in the EU so as to close regulatory loopholes is no more than a start. It is only part of the ‘banking union’ that will occupy the minds of Europe’s decision-makers for months to come.

If one side of the reform coin is about reining in excessive risk-taking, the other side is about what to do when it goes wrong. The concern about banks being too big to fail has not disappeared. In June last year Barnier proposed a bank recovery and resolution system that introduced for the first time the idea of ‘bail-ins’. Bank shareholders and creditors would be forced to accept losses to keep banks afloat before taxpayers would have to contribute. The proposal remains on the table without agreement between the Parliament and Council. The existing proposal calls for national resolution authorities to work together, but the real fight between member states will begin when the Commission proposes a fully fledged single resolution mechanism, giving a central authority the power to close down any bank in the eurozone.

An agreement is required, and fast. In a paper ordered by the Parliament’s economic and monetary affairs committee and published on 14 February, three distinguished economists described the “urgent need” to create a single resolution mechanism “by which even large, internationally banks can be resolved”.

Even this will not be the end of the story, said the authors, Thorsten Beck, a professor of economics at Tilburg University, Daniel Gros, director of Centre for European Policy Studies (CEPS), and Dirk Schoenmaker of the Netherlands’s Duisenberg School of Finance.

Even the best designed single resolution mechanism “will be useless if the authorities are too afraid of the systemic consequences of large failure to let any banks ever go under.”

They added: “At present very little bail-in takes place and no single bank is allowed to fail because of the fear to cause another ‘Lehman’.” They warn that if the policy of not allowing banks to fail continues, “Europe could find itself in a similar situation as Japan where the so-called ‘zombie’ banks held back the recovery for a very long time.”

The reform agenda does not stop with resolution. The Parliament and the Council are currently thrashing out a deal to make the European Central Bank the eurozone’s bank supervisor. On top of all that, Commission officials are still wrestling with the findings of the Liikanen report. This review for the Commission, concluded five months ago by Erkki Liikanen, the governor of Finland’s central bank, recomm-ended forcing banks to separate their retail and investment arms. Officials working for Barnier are analysing the reports’ findings, and have signalled that he will outline plans for the structural reform of banks before the summer. The college of European commissioners held an orientation debate on the topic yesterday (6 March).

The jigsaw is a long way from being finished. Completion comes closer with last week’s approval of bank prudential rules, but failure to address some of the larger questions that continue to haunt policymakers, such as whether to allow banks to fail, could mean that the leap forward for banking reform lands on foundations that are still shaky.